I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control.

Gross on using owner equivalent rent instead of home prices in calculating the CPI:

..... the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

Gross on hedonic quality adjustments:

In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.

Gross on the implications of understated inflation for asset prices:

But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates....... A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

From Bill Gross, “Hmmmmm?”, Investment Outlook, June 2008

I want to recommend that everybody take 15 or 20 minutes and read Bill Gross’s most recent Investment Outlook, out today, on the massive understating of real world inflation by the Consumer Price Index (CPI).

You need to understand inflation.  If you want to protect yourself and make money going forward, this is the #1 thing you need to understand.

In the article, he references “others have actually tracked the CPI that ‘would have been’ based on the good old fashioned way of calculation.  The results are not pretty, but are undisclosed here because I cannot verify them.” 

He’s referencing John Williams of Government Shadow Statistics.  Here is a chart of what the CPI would look like using the pre-1983, pre-1998 and current methodolies (via Government Shadow Statistics): CPI Now And Using Pre-1983 and Pre-1998 Methods Chart.

Read it.